Banks are financial institutions authorized by the government of India to accept deposits from customers(by opening accounts like savings, current, so that customers can deposit their money with banks), offer various kinds of loans to individuals & businesses and offer financial services like check clearing, net funds transfer and more.
To know more about types of banks and other details, read our detailed article about Banks in India
Why are banks important?
Since banks can hold deposits(hard earned money) from the end customer(the common man like you and me), it is very important that they remain afloat irrespective of the economic conditions of a country. Since if a bank fails (ie they do not have enough money to pay their account holders) – common man would potentially lose their life’s earning and this could lead to the collapse of entire economy & banking system.
Because of the importance of banking system in an economy, all banks of a country are regulated by a central bank and this bank is RBI(Reserve bank of India) for India.
Role of Reserve Bank of India
RBI is one of the most important organizations in India and few important roles of RBI are:
- Issuing & enforcing regulations for Banks, NBFC’s and other financial institutions in India to maintain the confidence of all customers in the financial & banking system.
- Controlling the supply of money in an economy based on factors like inflation & GDP growth rate etc using tools like repo rate, reverse repo rate etc.
- Maintain foreign currency liquidity & reserve so that India can manage all its foreign currency obligations(like oil imports).
- Issue of currency notes – RBI is the only body which can legally print notes in India. The notes printed by RBI serve as legal tender across India.
Different types of RBI Rates
As indicated in the section above, RBI uses various interest rates to manage liquidity in the economy. Let us understand, few important RBI rates:
Bank Rate(Also known as Discount Rate)
The rate at which Reserve Bank of India lends money to various commercial banks(like ICICI, SBI, Axis and others) in India without keeping a collateral. After receiving the money from Reserve Bank of India, commercial banks typically lend the money to end customers(for loans like home or car etc) or lend it to businesses(like Reliance or Tata Steel for further business expansion).
The bank rate signals the RBI’s long-term outlook on interest rates.
Bank rate is essentially the rate of interest at which commercial bank receives funds from RBI. Hence, it directly impacts the rate which commercial banks charge their customers for loans(end users and businesses).
For instance, if RBI sees that inflation is going up – this means that there is excess capital in the economy. To reduce inflation, RBI could increase the bank rate which would result in commercial banks to increase their interest rates(because now they have to pay more interest to RBI). Because of increase in interest rate by commercial banks, the EMI’s of end consumers and business(on existing loans) would also increase. Sine EMI would increase, the end consumers would have a lower amount of money left to spend on other activities(like shopping or going to a movie or going on holiday) and hence this should result in a reduction of inflation(because if fewer buyers are available, the prices on underlying commodities would reduce).
Repo rate is the rate of interest at which RBI lends money to a commercial bank for a short tenure of time with a collateral(in form of government securities). Generally, these loans are only for a short duration of time up to 2 weeks and the bank takes these loans when they need funds to meet their day to day operations.
Since a collateral is given while taking a repo loan, repo rates typically have lesser interest as compared to bank rate.
Let us take an example, if RBI sees that inflation is under control and growth is slowing down then RBI could reduce the repo rate. When the repo rate is reduced, the loan becomes cheaper and hence additional liquidity is introduced in the market. Also, businesses take more loans for expansion because “cheap money” is available and hence newer jobs are created.
Reserve Repo Rate
At times, banks have excessive liquidity available but do not have suitable opportunities for handing out loans. In these cases, banks have an option to deposit their excess funds with RBI and receive an interest payment from the central bank, this interest rate is called Reserve Repo Rate.
Reserve Repo Rate is typically used by RBI to pull capital from the market because if they raise this rate, more banks are likely to deposit their funds with RBI(because it is completely risk-free) and receive the interest payment.
Cash Reserve Ratio(CRR)
As discussed earlier, one of the most important roles of commercials bank like SBI, ICICI Bank etc is to give loans to business owners and end consumers which results in economic development. In order to give loans, banks need capital which they generally get from:
- RBI(By taking money on loan and paying either base rate or repo rate as interest).
- Customers Deposits(Using customers money deposited with them in Savings, Current or other bank accounts).
Since RBI does control the customer deposits, it came up with CRR(Cash Reserve Ratio). The CRR is a percentage of total bank deposits which should be deposited with RBI. Hence if the CRR is 6.5% and someone deposits Rs 100 into their bank account – the bank is required to deposit Rs 6.5 with RBI and use only the remaining Rs 93.5 as it seems suitable.
The CRR serves two purposes:
- A portion of bank deposit is risk-free, since it is deposited with RBI(Helpful in case of NPA’s)
- RBI controls the liquidity in banks and hence the economy.
Once again, if the banks increase the CRR then more of banks money would be deposited with RBI and hence lesser money would be available in the banking sector to give as a loan.
Banks do not earn interest on deposits made under CRR from RBI.
Statutory Liquidity Ratio(SLR)
Statutory Liquid Ratio is the percentage of bank deposits(set by RBI) which should be invested in specified financial securities like Central Government or State Government securities. Hence, if a saving account holder deposits Rs 100 with ICICI bank and SLR is @ 15%, then ICICI is required to invest Rs 15 into a pre-defined government based financial security.
Since the amount is invested in a security(like bond or gold), banks do earn “some” interest on these deposits(unlike CRR where banks do not earn any interest).
We hope that now you have a pretty good idea about various rates used by RBI to control inflation and cash liquidity in the market. If you have any questions, please do leave them in the comments section below.
You can get details about most recent rates from RBI’s rate list.